13th February 2008

Dear Investor,

Key Issues Identified in Recent Collapses

This is an extract of a letter sent to the ASIC by the Institute of Actuaries of Australia dated 31 July 2007 from the current President of the Institute Mr. Greg Martin regarding the Institute's views on why collapses of debenture and promissory note issuers WestPoint, Bridgecorp, ACR and others occurred.

Institute of Actuaries of Australia Letter to ASIC

Based on our observations, the above mentioned failures have involved a number of issues (not necessarily all applying in each case):

  • Labelling as "Debentures": Notwithstanding discussions of risk in prospectuses and other disclosure documents, there remains general misunderstanding in the public about "debentures". They are often seen or represented mistakenly as "deposits". Similar issues apply in the case of "mortgage trust" labelled investment schemes.
  • The nature of the risk: Apart from the fundamental disconnect between customer perceptions of the riskiness of the investment and the actual position, the risk manifests itself in quite a different way to many other investments. No loss at all may be apparent for significant periods of time, but then very high (often 100%) losses can manifest over a very short period.
  • Interest rates and returns provided: While these have typically been materially higher than bank term deposits, there are important questions as to whether they are fair relative to the actual risk undertaken and whether they give a fair indication of what the relative risks may actually be.
  • Property valuations: A typical valuation approach for development property is the estimated finished value times the percentage complete. This is subject to uncertainty and "assumptions control" with respect to the end valuation and we expect that the "percentage" approach would rarely indicate a reasonable mid-project realisation value.
  • Excessive debt leverage: Financing via debt structures to high "Loan to Value Ratio" levels for property development which, to the unsophisticated investor, appear "reasonable" against bank lending on residential property. This may conceal that the amount of risk capital invested is inadequate and/or lead to inappropriate labelling of capital raised as "debt" which is subject to risks more akin to equity.
  • Lack of alternative funding / exit strategies: Particularly in the case of property development, there is a fundamental liability-asset cashflow mismatch. The "debt" liability needs to have interest paid and maturities paid while the asset produces little, and usually negative, cash-flow to support the liability requirements. Funding the liability cashflows is usually based on future further debt raising (and debt rollovers). Little or no attention appears to be paid to alternative funding, sound exit strategies or "equity" risk capital funding if the "tap is turned off" for any reason.
  • Poor Budgeting and risk margining: Poor or optimistic budgeting and/or running to a risk margin too small relative to the range of potential outcomes (including unexpected events).
  • Disclosure failures: Long, complex disclosure documents with front page references to "secured over property", with the actual risks discussed beyond tenth page in the offer document. Failure to mention the key risk: that if the debt funding 'merry-go-round' is interrupted for any reason this may lead to an inability to complete the development.
  • Commission, soft dollar and conflict disclosure weaknesses and/or misconduct.
  • Definition of "retail": This remains at $500,000. This is not a large sum of money for a retired investor (they can easily mortgage their home to get this) or a DIY super fund. Many retail consumers invest sums of this order or more.
  • Fraud, deceptive conduct and misrepresentation.

Dealing with the Issues

There are a number of potential approaches for dealing with these issues. We set out below some preliminary thoughts for discussion.

Product and Labelling Alignment

If it is to be permissible for fund raising entities to raise investment and other funds direct from the public, then it is our view that long and complex disclosure documentation will not overcome basic product mislabelling. Indeed, this may often also be the case for products sold via other than fully licensed and specialist investment advisors.

A more reliable and meaningful approach to aligning products and labels is required, in terms of normal layman understanding.

Prudential Management Aligned to Labelling

Given the observations above, there is a good case that if a vehicle wishes to issue securities labelled as "debentures" (or similar) the issuer should be regulated more in accordance with their characterisation as a pseudo deposit-taking institution.

Some of the disclosure issued by these entities implies, quite strongly, that the securities offered are fully guaranteed by corporations which are akin to an ADI, or otherwise are as secure as a "bank mortgage".

Given the susceptibility of many consumers, particularly risk-averse, older consumers who are attracted to investments which purport to offer safe, regular and predictable returns, consideration should be given to requiring such an issuer to be some form of APRA-licensed entity with requirements commensurate to their label, e.g.:

  • minimum capital requirements for the issuing entities;
  • requirements for professional assessment of their financial soundness, at the outset and at least annually thereafter, including assessment of their asset and income coverage, liquidity and the adequacy of risk management frameworks (the latter to include allowance for risks in any party that funds are invested in or lent to); and
  • fit and proper requirements for directors of that entity.

Equally, however, if such a product is issued via a managed investment structure and labelled suitably as "risk capital" or "equity" then it may be that the existing ASIC consumer protection regime (with some amendments - see below) would be adequate.

Securities issued from trusts labelled "mortgage trusts" may require some considerable tightening around actual asset holdings, including an expectation that the above debenture security requirements would apply to the majority of the mortgage issuing entities in which the trust invests.

While prudentially based measures such as those described above are not normally associated with regulation of investment schemes in Australia, we believe this is a matter that should be re-visited in light of recent events.

Succinct & Prominent Risk Disclosure

As noted above, complex and detailed disclosure has not been effective at protecting consumers or explaining risks under direct to public offers. We believe this will also be the case in respect of products promoted or distributed through other than fully licensed and specialist investment advisors.

A prescribed, succinct and prominent "risk warning" aligned with the product "label" (e.g. similar to the PDS requirement for fee disclosure) may be considered. This could include statements as to:

  • Level of risk involved in the underlying assets or security.
  • Marketability (liquidity) of the underlying assets or securities.
  • Underlying cash-flow risks and financial structure resilience.
  • Key investment loss risks.
  • ASIC could require the product promoter to obtain some suitable independent professional assessment of the reasonableness of the product risk warning and labelling.
Reprinted with permission of the Institute of Actuaries of Australia.
Best regards,
Chris Andrews

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Chris Andrews
Head of Funds Management

t  +61 3 8610 2811
e  candrews@latrobefinancial.com.au

Chris Andrews is the Head of Funds Management for the La Trobe Group and has responsibility for the La Trobe Australian Mortgage Fund.
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La Trobe is one of Australia's leading independent specialist mortgage Financiers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Mortgage Funds under AFSL 222213. It employs over 115 staff and has raised over AUD$10Billion to assist over 100,000 customers since inception in 1952.

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